EXECUTIVE SUMMARY

The performance of U.S. value over the last decade has led many to wonder whether the value premium has been completely eroded. We analyze this question by decomposing the relative returns of cheap stocks in order to understand what has driven this change in performance. Our return decomposition suggests value stocks’ performance erosion can be evenly attributed to a reduction in the value premium and a widening of the value spread. Though value might deserve to trade at a greater discount today due to the market’s current dynamics, we believe that cheap stocks are still likely to deliver a premium and are therefore well-positioned to outperform the broad market.

Introduction

Whatever price multiple of which you are a fan, whichever sectors you exclude, however you neutralize your exposures, whether you equal-weight or cap-weight, one thing remains true: cheap stocks have had an unhappy decade.1 In some cases – as with sector-neutral value – they have only disappointed relative to previous outperformance. In others, such as the traditional Fama-French “HML” factor, mild disappointment would be a welcome change of pace. This is made clear in Exhibit 1, which depicts the total return of HML (currently 34% below its peak) and the length of each of its drawdowns (the most recent one has passed the 10-year mark).

Many explanations have been given for the disheartening performance of value in the post-GFC world. Some researchers contend that value previously earned above-average returns because investors extrapolated poor fundamental growth too far into the future, and that said behavioral bias has now come undone. Others believe that the commoditization of “smart beta” has led to factor crowding, and that this has eroded the value premium. A third camp believes that something more fundamental, such as increased concentration, has made growth companies inherently more competitive and put value companies at a structural disadvantage. And then there are those who think that nothing has truly changed, that the value premium is alive and well, and that in time the humble shall be exalted.

Each of the arguments above has some intuitive appeal. Consider the behavioral story. As investors become more sophisticated and biases get uncovered, those who exhibit these biases should suffer losses and become a smaller part of the market, while those who profit from them should become proportionately more relevant to price formation. As a result, if the value premium is a “pure” behavioral story, we would expect it to erode as it becomes better known. A similar version of this argument applies when we think of factor crowding. Even if the value premium was a rational compensation for some risk to which investors became exposed when they bought into cheap stocks, a sudden change in market preferences (due to, say, passive rules-based vehicles) would likewise change the required rates of returns for these stocks.